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• Monetary Approach to Exchange Rates

Rajesh Singh

Feb 6, 2018

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 1 / 20

• Absolute and relative PPP

Absolute

E\$/euro =PUSPEU

Relative PPP4E\$/euroE\$/euro

= US EU

The question is: How are price levels determined?

We need a theory of price level

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 2 / 20

• Absolute and relative PPP

Absolute

E\$/euro =PUSPEU

Relative PPP4E\$/euroE\$/euro

= US EU

The question is: How are price levels determined?

We need a theory of price level

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 2 / 20

• Absolute and relative PPP

Absolute

E\$/euro =PUSPEU

Relative PPP4E\$/euroE\$/euro

= US EU

The question is: How are price levels determined?

We need a theory of price level

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 2 / 20

• Absolute and relative PPP

Absolute

E\$/euro =PUSPEU

Relative PPP4E\$/euroE\$/euro

= US EU

The question is: How are price levels determined?

We need a theory of price level

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 2 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.

Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.

A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions and

in aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): M

Money market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Money, output, and inflation

The need to conduct transactions is in proportion to an individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

will cause a proportional increase in transactions andin aggregate money demand.

A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

Md = L PY

Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

P =ML Y

In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

• Exchange rate

US price level

PUS =MUS

LUS Y US

EU price level

PEU =MEU

LUS Y EU

Exchange rate

E\$/euro =PUSPEU

=MUS

LUS Y US

MEULUS Y EU

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 4 / 20

• Exchange rate

US price level

PUS =MUS

LUS Y US

EU price level

PEU =MEU

LUS Y EU

Exchange rate

E\$/euro =PUSPEU

=MUS

LUS Y US

MEULUS Y EU

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 4 / 20

• Exchange rate

US price level

PUS =MUS

LUS Y US

EU price level

PEU =MEU

LUS Y EU

Exchange rate

E\$/euro =PUSPEU

=MUS

LUS Y US

MEULUS Y EU

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 4 / 20

• Money, output, and inflation

In the equation P = ML Y , L is a constant.

If M Changes by % and Y changes by g%, by how much % does Pchange?

Inflation

=4PP

=4MM

4YYg

4LL0

Thus, = g

Question 1:5 3 = 2%

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 20

• Money, output, and inflation

In the equation P = ML Y , L is a constant.

If M Changes by % and Y changes by g%, by how much % does Pchange?

Inflation

=4PP

=4MM

4YYg

4LL0

Thus, = g

Question 1:5 3 = 2%

Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 20

• Money, output, and inflation

In the equation P = ML Y , L is a constant.

If M Changes by % and Y changes by g%, by how much % does Pchange?

Inflation

=4PP

=4MM

4YYg

4LL0

Thu